Aurora Paper

Aurora Textile Company Case Summary

Introduction Aurora Textile Company (hereinafter “the Company”) is a yarn manufacturer that produces cotton and synthetic/cotton blend yarns. The Company has operated for around 100 years, with the domestic textile market creating about 90% of the Company’s revenue. The Company has four major customer segments, listed from the largest percentage of sales to the least, they are: hosiery, knitted outerwear, wovens, and industrial and specialty products. Recently, the U.S textile industry has undergone some hardships. One reason is that several apparel makers have relocated their production facilities to Asia in search of lower costs. Another issue is that consumers (especially in high-end markets) have little tolerance for yarn defects. With the advent of better information technology systems, the liability costs of yarn producers has increased due to the new ability to trace yarn defects back to the producer. Because of these hardships, the Company’s sales have been steadily declining. In 2000, the Company closed four manufacturing facilities. The Company currently has four plants remaining in operation. The Hunter plant is seeking installation of a new ring-spinning machine, the Zinser 351. This machine would yield higher quality yarn, allowing for sales in a niche market that would increase the selling price of yarn by 10%. Additionally, operating costs would be reduced through greater production efficiency. One downside is that sales volume would be 5% lower and another is that the cost of customer returns (although less frequent) would be higher. The following is an analysis of cash flows showing whether Michael Pogonowski should invest $8.25 million and purchase the new machine.

Analysis Payback Period The Payback Period is used to determine the length of time that is required to recover the cost of the initial investment of a project. With the payback period there are two disadvantages; one it does not take into account the time value of money and second it ignores the benefits that occur after the investment is paid back. In the case of Aurora Textile the payback period is 1.9945 years. Assuming a 1% annual inflation, the Payback Period is 1.9753 years. For the calculation of the Payback Period, see Exhibit 2. Discounted Payback Period The Discounted Payback Period will take into account the time value of money by discounting the future cash flows to “time zero.” Using the Discounted Payback Period Aurora Textile will earn back their initial investment in 2.4095 years. As with the Payback Period, the Discounted Payback Period still does not recognize the benefits that occur after the investment is returned. Assuming a 1% annual inflation, the Discounted Payback Period is 2.4212 years. For the calculation of the Discounted Payback Period, see Exhibit 2. Though both the Payback Period and Discounted Payback Period are tools Aurora Textile Company can use to determine whether they should buy Zinser 351 Machine, the sole decision should not rely on these two methods alone as they do not determine the overall profitability of the project. Profitability Index

The Profitability Index calculates how much excess returns a Company is receiving for investing in a project. The higher the Profitability Index, the better the project. This calculation takes the present value of expected cash inflows divided by the present value of expected cash outflows. The project should be accepted if the ratio is greater than 1.0. For Aurora Textile, the Profitability Index is 2.73. Assuming a 1% annual inflation, the Profitability Index is 3.06. Because this ratio is greater than 1.0, the project should be accepted using this decision rule by itself. For the calculation of the Profitability Index, see Exhibit 5. Average Accounting Rate of Return The Accounting Rate of Return uses Net Income to calculate the return on investment a Company receives on a project. The higher the Accounting Rate of Return, the better the project. The percentage return is calculated by taking the project’s average Net Income per year divided by the average Book Value per year. If the projected returns an expected Accounting Rate of Return greater than the target return of the Company, the project should be accepted. This calculation is best utilized when comparing more than one mutually exclusive project. The project with the highest Accounting Rate of Return is the one that should be accepted. For Aurora Textile, the Accounting Rate of Return is 0.32. This means the Company is receiving less Net Income from the project than the book value of the equipment. Additionally, when looking at each year individually, the ratio does not become greater than 1.0 until years 9 and 10 of the project. Assuming a 1% annual inflation, the Accounting Rate of Return is 0.35. As a result, the project should be rejected using this decision rule alone. For the calculation of the Accounting Rate of Return, see Exhibit 6.

Net Present Value Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows, which is a central tool for using the time value of money to evaluate the potential of a long-term investment project. The calculation of present value of cash inflows (PV) is based on discounted cash flow (DCF) analysis that uses future free cash flow projections and discounts them using WACC. The calculation of NPV should take inflation and returns into account. If the NPV of a project is positive, it should be accepted. Using a 10% discount rate, the NPV of the resulting cash flows for this ten-year project is 14.24 million, suggesting that the investment for purchasing a new ring-spinning machine, the Zinser 351, would add huge value to the firm, see Exhibit 5. Assuming a 1% annual inflation, the NPV is 15.30 million. Even assuming that the project can last only four years and has a zero salvage value––a sensitivity analysis, the calculated NPV is still positive value with 3.69 million (3.72 million if taking the inflation rate of 1% into account), see Exhibit 5. According to the NPV analysis, the project may be accepted. Internal Rate of Return The internal rate of return (IRR) is a rate of return used in capital budgeting that makes the net present value of all cash flows from a prospective project equal to zero, to measure the profitability of an investment. Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake the project. The calculated IRR for this project is 45.96%, much higher than the discount rate of 10%, also demonstrating that it is desirable to undertake this project, see Exhibit 6. Even if the project can last only four years, the IRR for Aurora Textile is 31.41%, still indicating a feasible project, see Exhibit 6. Based on the analysis on the project’s

IRR, it is an acceptable investment. Conclusion Michael Pogonowski should purchase the Zinser 351 for the Hunter production facility. The attached exhibits illustrate all decision rules assuming both no inflation and alternatively assuming 1% inflation. The discount rate used is the 10% hurdle rate that the Company has deemed appropriate for this type of replacement decision. When 1% inflation is calculated into the cash flows, the discount rate is increased to 11% to maintain continuity between the cash flow and discount rate. Additionally, our cash flows do not reflect the $15,000 spent on marketing research or the $5,000 for engineering tests as these are sunk costs and should not be weighed into the replacement decision. The payback period is less than two years and the discounted payback period of 2.4095 is only slightly above the 2 year rule of thumb. The profitability index of 2.73 is greater than 1. The average accounting rate of return (AARR) is 0.32, which is admittedly lower than most companies would set as a target. However, the net present value of the company is positive 14.24 million, and the internal rate of return is 45.96%, which is greater than the discount rate of 10%. Thus, all decision rules except for AARR indicate that replacement is a wise decision. It is important to remember that external factors may also play a role in Michael’s decision. For example, alterations to the assumptions about increases in sales volume, decreases in return volume, and the adjustment for inflation could all greatly affect the decision rule outcomes. Thus, Michael must be confident in all assumptions the Company is making. Finally, our analysis shows that NPV and IRR indicate the replacement should be made if the company can remain in operation for at least four years. Michael must be confident in the

continued operation of Aurora Textile Company when deciding to purchase the Zinser 351.